International Trade

Policies
Free Trade VS Protectionism
• Trade between the countries can either be the free trade or the
protected trade.

• Free trade refers to a trade of goods and services between countries

which is not impeded by government restrictions or interventions.

• Protectionism refers to an economic policy which restricts trade

between the economies.
Free Trade
A trade policy in which no restrictions on the movement of goods
between countries is known as the policy of Free trade.

• Free from all the tariff and non-tariff barriers.

• Permits the flow of international commerce in its natural environment
and is free from all artificial impediments
• Enables nations to focus on their core competitive advantages
(maximising economics output, growth)
• The idea that free trade is welfare enhancing - fundamental doctrines in
Adam Smith (1776) , David Ricardo (1816).
Arguments for Free Trade
1. The theory of Comparative Advantage
• Ricardo –Specialising and trading goods in which countries have a lower opportunity
cost or greater comparative advantage - Economic welfare for all the countries
• Free trade requires countries to do specialisation in those goods having comparative
advantage.

2. Better utilisation of factors of production

• Free trade leads to the most economic utilization/ efficient utilization of the productive
resources
• Under free trade each country specialises in the production of those goods for which it
is best suitable and import those goods from the other countries in which the nation
has comparative disadvantage
Arguments for Free Trade
3. Reduction in Tariff Barriers leads to creation of trade
• Trade happens when consumption shifts from high cost production to low cost
production
• Reducing the tariff barriers may help countries for trade creation

4. Lower prices of imported goods

Consumers benefit via lower prices, producers benefit as factors of production are
employed in more fruitful and specialised production which gives better earnings
Arguments for Free Trade
5. Increased Competition
• Free trade leads to competition (domestic firms encounter competition from
abroad)
• Motivation to cut costs and increase efficiency
• It may prevent domestic monopolies from charging too high prices and the
inefficient producers forcefully improve their efficiency or quit.
6. Economic Growth
• Better living standards, rising real incomes and increased rates of economic
growth.
• Which is achieved by more competitive industries, efficiency, increased
productivity and the production levels
Arguments against Free Trade

• Under the system of free trade, the underdeveloped countries suffer very much
in competition with the advanced countries.
• Countries cannot allow free import of injurious and harmful products hence
trade restrictions become very much necessary.
• Developing or new industries may find it difficult to become established in a
competitive environment with no short term protection policies by government.
• Free trade can lead to pollution and environmental problems as companies fail
to include these costs in the price of goods in trying to compete with countries
operating under weaker environmental legislation in some countries.
Protectionism
Protection refers to the policy of encouraging domestic industries by
providing subsidies to home producers or more usually by imposing
restrictions on foreign products

• Tariff and non Tariff Barriers

Arguments for Protectionism
1. Economic Argument

• Infant Industry Argumen- The entity which has come new in the
market, not grown up enough to stand competition from well-
developed foreign industries.

• The argument affirms that protection is necessary for small and newly
established firms particularly in less developed economies
Arguments for Protectionism
2. Strategic arguments
• It means use of a tariff to protect military capability.
• Consuming the goods produced by domestic country for the production of national industry
and so, if the war happens domestic country don't need to indulge in buying products from a
foreign country and domestic industries would have the necessary capacity for producing all
the necessary goods.
• Tariffs to reduce the dependence on international resources- Self reliant

3. Conservation of exhaustible natural resources argument

• Production for export market may involve early of irreplaceable natural resources like gas,
oil and coal.
• Export duty is an undesirable measure to balance the needs of present and the future
generation.
Arguments Against
Protectionism
• Protectionism may raise prices to consumers and producers of the imported
products.
• Protected trade would lead to less choice for consumers due to high prices.
• Protectionism distorts comparative advantage, leading to the inefficient use of
world’s resources.
• Specialisation is reduced and this would reduce the potential level of world’s
output.
• Competition would diminish if foreign firms are kept out of country and so
domestic firms may become inefficient without the incentive to minimise the cost.
• The motive to innovation will also be reduced
• Protectionism may hinder the economic growth
Trade Barriers
Trade barrier is a governmental restriction on the movement of
international products or services. Governments restrict trade to protect
industries from foreign competition by using two main tools:
• Tariffs
• Non-Tariff Barriers

A tariff is a tax/duty/levy on a good that is imposed by the importing

country when an imported good crosses its international border.
A nontariff barrier is any action other than a tariff that restricts
international trade.
Tariff Barriers
When two nations trade in commodities, the country in which the goods
are exported levies a tax in order to generate revenue for the government
while also raising the price of foreign goods so that domestic firms can
compete with foreign products.
The fee is in the form of a tax or duty which is referred to as a Tariff
Barrier.
The amount of tax or duty levied as a tariff is added to the cost of the
import, making foreign goods more expensive, which is ultimately borne
by the product’s customer.
The tariff is paid to the customs authorities of the country where the
goods are being sent.
Tariff Barriers
Revenue Tariff

On the basis of Protective

Purpose Tariff

Prohibitive
Tariff

Single Column
Tariff
Classification of
Tariff On the basis of Double Column
Discrimination Tariff

Multiple
Column Tariff

Retaliatory
Tariff
On the basis of
Retaliation
Countervailing
Tariff
Tariff Barriers-On the basis of
Purpose
Revenue Tariffs
Aim to generate income for the government.
Example: Tariffs on luxury imports to increase government revenue.

Protective Tariffs
Imposed to protect domestic industries from foreign competition.
Example: High tariffs on imported steel to support local steel producers.

Prohibitive Tariffs
Set so high that they prevent imports entirely.
Example: Extremely high tariffs on certain imported weapons or hazardous products.
Tariff Barriers-Protective Tariff

Specific Tariffs
• A specific tariff is a tax imposed directly onto one imported good and does not
depend on the value of that imported good.

• A specific tariff is usually based on the weight or number of imported goods.

• This tariff can vary according to the type of goods imported. A large portion of
agricultural goods falls into the specific tariff category.
• Purpose: Protects industries that produce bulk or commodity goods. Example: Rs.5
per kilogram of imported sugar.
Tariff Barriers-Protective Tariff
Ad Valorem Tariffs
• The term “ad valorem” is Latin for “according to value,” this type of
tariff is set based on a percentage of what the good is worth.
• A good way to differentiate between ad valorem tariffs and specific
tariffs is to look at how they are listed.
• Ad valorem tariffs will be listed as percentages, while specific tariffs
will be listed as a price per quantity.
• Purpose: Protects industries producing high-value goods.Example:
10% tariff on imported cars.
Tariff Barriers-Protective Tariff
Compound Tariffs
• A compound tariff is a combination of an ad valorem and specific
tariffs.
• It imposes a tax on imported goods based on the number of imported
goods and their value.
• To determine if the tariff imposed is a compound tariff, the tariff
imposed will have both a price per quantity and a percentage.
• Purpose: Provides extra protection by covering both low-cost and
high-value imports. Example: Rs2 per unit plus 5% of the item's value
on imported electronics.
Tariff Barriers-On the basis of
Discrimination
Single Column Tariff

A single set of tariff rates that apply uniformly to imports from all countries, regardless of their
origin or trade agreements.
Purpose: Ensures equal treatment across all trading partners, simplifying tariff administration.
Example: If a country sets a 10% tariff on all imported shoes, then this rate applies to every country
exporting shoes to that market without any variations.
Tariff Barriers-On the basis of
Discrimination
Double Column Tariff
• A dual system with two separate columns or schedules of tariffs. The two columns
apply different rates depending on the trade status of the exporting country.
• Types within Double Column Tariff:
• Most Favored Nation (MFN) Tariff: Lower rates for countries with favorable trade agreements.
• General Tariff: Higher rates for countries without trade agreements or preferential status.

• Purpose: Allows for differentiated tariff rates, incentivizing trade agreements and
offering preferential treatment to allied or partner countries.
• Example: A country may impose a 5% tariff on goods from partner nations under
trade agreements (MFN rate) but apply a 15% rate for goods from countries without
such agreements.
Tariff Barriers-On the basis of
Discrimination
Multiple Column Tariff System
A system with three or more sets of tariff rates applied based on the level of trade
agreement or relationship between the countries involved.
Purpose: Allows a country to tailor tariffs based on a range of trade agreements,
economic partnerships or diplomatic relationships, providing the flexibility to reward or
incentivize certain countries.
Advantages of a Multiple Column Tariff System
• Flexibility: Allows a country to use tariffs strategically, fostering stronger economic ties with some nations
while imposing barriers on others.
• Incentives for Trade Agreements: Encourages countries to enter trade agreements to secure lower tariffs.
• Policy Leverage: Provides tools for economic diplomacy and enforcement of international trade standards
Tariff Barriers-On the basis of
Discrimination
Types of Columns in a Multiple Column Tariff
Most Favored Nation (MFN) Tariff Rates: Lower tariff rates applied to World Trade
Organization (WTO) members or countries with MFN status.
Preferential Tariff Rates: Reduced rates for countries with special trade agreements,
such as free trade agreements (FTAs), regional trade blocs, or economic unions.
Example: Preferential rates for goods from countries within the European Union or
NAFTA.
General Tariff Rates: Higher rates applied to countries without any specific
agreements or preferential treatment.
Special Tariff Rates: Additional, often higher rates for certain countries based on
specific circumstances, such as trade disputes, sanctions, or anti-dumping measures.
Tariff Barriers-On the basis of
Retaliation

• Tariffs imposed in response to tariffs set by another country.

• Purpose: To pressure other countries to remove or reduce their tariffs.
Tariff Barriers-On the basis of
Retaliation
Retaliatory Tariffs
• Tariffs imposed by a country as a reaction to tariffs or trade barriers set by
another country.
• Purpose: To pressure the other country into removing or reducing its tariffs by
making their exports more expensive in the retaliating country’smarket.
• Example: If Country A imposes high tariffs on Country B’s goods, Country B may
respond by imposing its own high tariffs on goods from Country A as a
countermeasure.
• Retaliatory tariffs are often seen in trade disputes, where countries impose tariffs
on each other’s goods in a back-and-forth manner (e.g., the U.S.-China trade war,
where both countries imposed tariffs on each other’s goods).2.
Tariff Barriers-On the basis of
Retaliation
Countervailing Duty (CVD)
• A duty imposed on imported goods that receive unfair subsidies from their
government, which make them cheaper in foreign markets and put local industries at a
disadvantage.
• To level the playing field by offsetting the benefit of the subsidy and protecting the
domestic industry from unfair competition.
• Example: If Country C’s government heavily subsidizes its steel industry, making its steel
products much cheaper in Country D’s market, Country D can impose a countervailing
duty on Country C’s steel to neutralize the subsidy’s effect.
• Countervailing duties are typically used after an investigation determines that subsidies
are causing material harm to domestic producers. They are regulated under the rules of
the World Trade Organization (WTO) to ensure fair international trade practices.
Tariff Barriers-On the basis of
Retaliation
Key Differences in Objective
Retaliatory tariffs are aimed at pressuring the other country to change its trade
policies, while countervailing duties specifically target subsidized goods to protect
local industries from unfair competition.
Non-Tariff Barriers
Non-tariff Barriers are non-tax measures used by the government of a
country in order to restrict imports from foreign countries.
It includes constraints that result in prohibition, formalities, or
circumstances that make imports of commodities difficult and reduce
market potential for foreign products.
These are quantitative and exchange controls that have an impact on
trade volume, pricing, or both.
It might be in the form of laws, policies, practices, conditions, and
requirements imposed by the government to limit imports.
Non-Tariff Barriers
Quotas
• One of the most restrictive forms of protectionism is the quota.
• Quotas involve restriction of imports of a good to a definite quantitative level.
• Countries often issue quotas for importing and exporting both goods and
services. With quotas, countries agree on specified limits for products and
services allowed for importation to a country.
• In most cases, there are no restrictions on importing these goods and services
until a country reaches its quota, which it can set for a specific timeframe.
• Additionally, quotas are often used in international trade licensing
agreements.
Non-Tariff Barriers
Voluntary Export restraints
• Exporting countries sometimes use voluntary export restraints. Voluntary export
restraints set limits on the number of goods and services a country can export to
specified countries.
OR
• Where an importing country induces another nation to reduce its exports of a
commodity “voluntarily”, under the threat of all round restrictions, when these
exports threaten an entire domestic industry.
• These restraints are typically based on availability and political alliances.
• VERs are often created because an exporting nation might agree to voluntarily
comply because it may want to avoid damaging its relationship with a foreign
government and country’s consumers.
Non-Tariff Barriers
• VERs are generally imposed at the request of importer for providing a
protection measure for its domestic businesses producing substitute
goods.
• VERs is indeed like import quota where the licenses are authorized to
foreign governments and therefore is very expensive for the
importing country.

Example: Japan levied a VER on its auto exports into the U.S. resulting
from 1980s American pressure. The VER finally gave the U.S. auto
industry some protection against a high foreign competition.
Non-Tariff Barriers
Licenses
• Countries may use licenses to limit imported goods to specific businesses. If a
business is granted a trade license, it is permitted to import goods that would
otherwise be restricted for trade in the country.
Embargoes
• Embargoes are when a country–or several countries–officially ban the trade of
specified goods and services with another country. Governments may take this
measure to support their specific political or economic goals.
Sanctions
• Countries impose sanctions on other countries to limit their trade activity. Sanctions
can include increased administrative actions or additional customs and trade
procedures that slow or limit a country’s ability to trade.
Non-Tariff Barriers
Local Content Requirements
• Local Content requirement is a regulation in which some definite fraction of a
final good should be produced domestically.
• It may be specified in value terms, by requiring that some minimum share of
the value of a good represent domestic value added or in physical units
• The developing countries have widely used Local content laws which are trying
to shift their manufacturing base from assembly back in to intermediate goods.
• From the view point domestic producer of inputs, a local content requirement
provide the protection in the same way as an import quota does
• Local content does not place a strict limit on imports. Rather it allows the firms
to import more, provided that they also buy more goods domestically
Tariff Barriers-Protective
Tariff/Non-Tariff Barrier

What is Dumping?
• Selling goods in a foreign market at a price lower than their normal
value (domestic price or cost of production).
• Often done to gain market share, eliminate competitors, or get rid of
excess supply
• Example: Exporting steel to another country at prices lower than in
the home market.
Tariff Barriers-Protective Tariff
Forms of Dumping
Sporadic Dumping
Sporadic dumping is the occasional sale of a commodity at below cost or at a lower price
abroad than domestically in order to discharge an unanticipated and temporary surplus of
the commodity without having to reduce the domestic prices.
Predatory Dumping
Predatory Dumping is the temporary sale of a commodity at below cost or at a lower price
abroad to knock out foreign producers out of the market, post which prices are increased so
as to reap the fruits of the newly acquired monopoly abroad.
Persistent Dumping
Persistent Dumping is a continuous tendency of a domestic monopolist to maximize total
profits by selling the commodity at a higher price in the domestic market than the
international market.
Tariff Barriers-Protective Tariff
Causes of Dumping

• Producers in one country are trying to be in competition with the

producers in the other country.
• Producers are trying to clear off excess stuff which they are not able
to sell in their own country.
• Producers can make profit by dividing sales in to domestic and foreign
markets and then charging each market whatever price the buyers are
willing to pay
Tariff Barriers-Protective Tariff
Impacts of Dumping

• Negative Impact on Domestic Industries: Local producers struggle to

compete with low-priced imports.
• Market Distortion: Creates an imbalance in pricing, potentially leading
to monopolistic behavior by the foreign company.
Tariff Barriers-Protective Tariff
Anti-Dumping

Measures imposed by countries to protect their domestic industries

from dumped products.

Goal of Anti-Dumping Measures: Level the playing field for domestic

producers and ensure fair competition.

Mechanism: Primarily through additional tariffs (anti-dumping duties).

Tariff Barriers-Protective Tariff
How Anti-Dumping Works

1: Investigation – The government investigates whether dumping is

occurring and if it harms the domestic industry.
2: Determination of Injury – Authorities must prove that dumping has
caused material harm.
3: Imposing Duties – If proven, anti-dumping duties (extra tariffs) are
applied to bring prices in line with fair value
Effects of Tariff-Partial Equilibrium
Analysis
Assumptions:
• The demand and supply curves of the given commodity are concerned with
home country that imposes import tariff.

• The given demand and supply curves remain constant.

• There is no change in consumers’ tastes, prices of other commodities and

money income of the consumers.

• There is an absence of technological improvements, externalities and other

factors that result in changes in cost conditions.
Effects of Tariff-Partial Equilibrium
Analysis
• Imported product and home-produced product are perfect substitutes.

• There is no change in the foreign price of the commodity.

• There is an absence of transport costs.

• The foreign supply curve of commodity is perfectly elastic.

• Domestic production of commodity takes place at increasing costs.

Effects of Tariff-Partial Equilibrium
Analysis
Effects of Tariff-Partial Equilibrium
Analysis
1. Production Effect:

Pre-Tariff Scenario:

Price (OP): Initial world price of the commodity.

Domestic Supply (OQ): Quantity supplied domestically.

Domestic Demand (OQ1): Quantity demanded domestically.

Imports (QQ1): The gap between domestic demand and supply filled by imports.
Effects of Tariff-Partial Equilibrium
Analysis
Post-Tariff Scenario:

Tariff (PP1): A tariff raises the price of the imported good.

New Price (OP1): The new, higher price after the tariff.

Shift in World Supply Curve: The world supply curve shifts from PW to P1W1
due to the tariff.
Effects of Tariff-Partial Equilibrium
Analysis
Effects of the Tariff:

Demand Decrease (OQ1 to OQ2): Higher price reduces the quantity demanded.

Increase in Domestic Supply (OQ to OQ3): Domestic production rises as local

producers find it profitable to produce more.

Reduction in Imports (QQ1 to Q2Q3): The increased domestic production and

reduced demand lead to fewer imports.

The increase in domestic production (QQ3) replaces some of the imported goods,
helping local industries grow. This is known as the production effect or import-
substitution effect
Effects of Tariff-Partial Equilibrium
Analysis
Effects of the Tariff:

Demand Decrease (OQ1 to OQ2): Higher price reduces the quantity demanded.

Increase in Domestic Supply (OQ to OQ3): Domestic production rises as local

producers find it profitable to produce more.

Reduction in Imports (QQ1 to Q2Q3): The increased domestic production and

reduced demand lead to fewer imports.
Effects of Tariff-Partial Equilibrium
Analysis
1. Consumption Effect

Pre-Tariff Consumption:

Price (OP): Initial world price under free trade.

Total Consumption (OQ1): Total quantity consumed at the free-trade price.

Domestic Consumption (OQ): Consumption of home-produced goods.

Foreign Consumption (QQ1): Consumption of imported goods.

Price (OP): Initial world price of the commodity.

Effects of Tariff-Partial Equilibrium
Analysis
Post-Tariff Scenario:
Tariff Increases Price (OP1): The price rises due to the tariff.
New Consumption Level (OQ2): Total consumption decreases from OQ1 to OQ2
at the higher price.

Changes in Consumption:
Domestic Consumption Increase (OQ to OQ3): Consumers buy more locally
produced goods.
Foreign Consumption Decrease (QQ1 to Q2Q3): Demand for imports drops.
Reduction in Total Consumption (Q1Q2): Overall reduction in consumption due
to higher prices.
Effects of Tariff-Partial Equilibrium
Analysis
Welfare Effect

The imposition of tariff, on the one hand, causes a reduction in consumer’s

satisfaction and, on the other hand, provides a larger producer’s surplus or
economic rent to domestic producers and revenues to the government. Thus
tariff leads to redistributive effect in the tariff-imposing country.

Loss in Consumer’s Surplus = RHP – RCP1 = PHCP1

Gain in Producer’s Surplus = TBP1 – TAP = PABP1

Effects of Tariff-Partial Equilibrium
Analysis

Gain in Revenues to the Government = BCEF

Net Loss = PHCP1 – (PABP1 + BCEF)

= ΔBAF +Δ CEH
Effects of Tariff-General Equilibrium
Analysis
Why General Equilibrium Analysis?

• Tariffs lead to an economic welfare loss.

• Higher prices for both imported goods and domestically produced import
substitutes. The tariff's cost is fully borne by the tariff-imposing country.

• Partial equilibrium analysis offers limited insight into welfare effects. To fully
assess welfare implications, we must consider a general equilibrium
approach.
Effects of Tariff-General Equilibrium
Analysis
Domestic Country Characteristics (Country 1)

• Country is small, so it cannot influence international prices or the terms of

trade.

• This means it takes the prices of Goods X and Y as given by the world market.

• Country exports Good X and imports Good Y, so it sells Good X at the world
price 𝑃𝑋 and buys Good Y at the world price 𝑃𝑌
Effects of Tariff-General Equilibrium
Analysis
Objective:

Nation 1 aims to maximize its welfare, which depends on both the production
of goods (how much of each good is produced) and the consumption of goods
(how much of each good is consumed).

To achieve this, Nation 1 will produce at the point where the domestic ratio of
marginal costs equals the world terms of trade (i.e., where the opportunity cost
of producing one good over the other matches the relative price ratio given
by 𝑃𝑋/𝑃𝑌).
Effects of Tariff-General Equilibrium
Analysis
Production at Point P1 :
Tangency Condition: The point P1 on the PPF is where the slope of the PPF is
tangent to the line with the slope 𝑃𝑋/𝑃𝑌 .
This slope represents the world price ratio or terms of trade for Nation 1.

Why Tangency Matters:

At this tangency point, the country is producing a mix of Goods X and Y that
aligns with the prices it faces in the world market, making the best use of its
resources in production.
This production point ensures that the value of what Nation 1 produces (in
terms of world prices) is maximized, thus positioning it to gain the most from
trade.
Effects of Tariff-General Equilibrium
Analysis
Budget Constraint:

The line passing through P1 with a slope of 𝑃𝑋/𝑃𝑌 is also Nation 1’s budget
constraint.
It shows all combinations of Goods X and Y that Nation 1 can afford to
consume, given its income from exports.

Consumption Choice:
Within this budget constraint, Nation 1 will choose a consumption point that
maximizes its utility.
This is where the budget line is tangent to the highest possible indifference
curve (representing the greatest level of satisfaction), marked as point C1.
Effects of Tariff-General Equilibrium
Analysis
Consumption at Point C1:
Indifference Curve Tangency: Point C1 on the indifference curve represents the
combination of Goods X and Y that maximizes Nation 1’s welfare (or
satisfaction) given its budget constraint.

Why Tangency to Highest Indifference Curve Matters:

When the budget line is tangent to the highest possible indifference curve, it
means that Nation 1 is reaching the highest level of satisfaction it can afford,
balancing the amount it can produce with what it can consume.
Effects of Tariff-General Equilibrium
Analysis

Good X-FOOD
GOOD Y-CLOTH
Effects of Tariff-General Equilibrium
Analysis
Price Effects of the Tariff on Commodity Y:
Before the tariff:
The price of Commodity Y in the domestic market is equal to the world price 𝑃𝑌
and consumers in Nation 1 pay the same price as the rest of the world.

After the tariff:

The government imposes a tariff on Commodity Y, which increases the price of
this good for both consumers and producers in Nation 1.
The domestic price of Commodity Y increases by the amount of the tariff.
Effects of Tariff-General Equilibrium
Analysis
• For consumers: They now face a higher price for Commodity Y than before.

• For producers: The price they receive for selling Commodity Y domestically
(after the tariff) is higher than the world price, which may create incentives
for domestic production to increase, even though the tariff reduces the
quantity of imports.
Effects of Tariff-General Equilibrium
Analysis
Divergence Between Domestic and World Terms of Trade:

World Terms of Trade (TT):

The world price ratio of Goods X and Y, represented by the line TT, reflects the international price
ratio. This line is the budget constraint before the tariff, and the nation consumes at the point
where this line is tangent to the highest indifference curve.

Domestic Terms of Trade (DD):

After the tariff is imposed, the domestic price ratio becomes steeper, represented by the line DD.
The new slope of this line reflects the increased price of Commodity Y domestically relative to
Commodity X due to the tariff. This creates a divergence between the domestic and world price
ratios.
Effects of Tariff-General Equilibrium
Analysis
Angle Between DD and TT:
The difference between the slopes of the two price lines (the world price line
𝑇𝑇 and the domestic price line 𝐷𝐷) shows the wedge created by the tariff.

This wedge is essentially the angle between the two price lines, which
demonstrates how the relative price of Commodity Y has increased
domestically due to the tariff.

Reason for the wedge: The tariff creates a price distortion in the domestic
market. While the world price ratio (represented by 𝑇𝑇) reflects international
market conditions, the domestic market (represented by 𝐷𝐷) is now distorted
by the government’s intervention.
Effects of Tariff-General Equilibrium
Analysis
Price Effects and Production Shifts:
Higher Price of Commodity Y: The tariff raises the domestic price of
Commodity Y, which encourages producers to increase the production of
Commodity Y and reduce the production of Commodity X.
This causes the economy to move from its original production point P1 (before
the tariff) to a new production point P2 , where the domestic price line 𝐷𝐷
(after the tariff) is tangent to the production possibility curve.

New Production Mix: With the higher domestic price of Commodity Y, Nation 1
is now producing more of Commodity Y and less of Commodity X. This shift
results from the distortion in relative prices caused by the tariff.
Effects of Tariff-General Equilibrium
Analysis
International Trade After Tariff:

• The world price ratio 𝑇𝑇 remains unchanged, as the country is small and
cannot influence world prices. However, the domestic price line 𝐷𝐷 becomes
steeper, reflecting the increased relative price of Commodity Y in the
domestic market due to the tariff.

• The international trade now takes place along the line P2C2, which is parallel
to 𝑇𝑇, but with reduced trade volumes compared to the pre-tariff situation.
This implies that exports of Commodity X are reduced. Imports of Commodity
Y are reduced.
Effects of Tariff-General Equilibrium
Analysis
After the tariff is imposed, a new consumption equilibrium is reached under
two conditions:

Condition 1: The domestic price line 𝐸𝐸, with a slope equal to the tariff-
distorted domestic price ratio, must be tangent to an indifference curve
representing the consumer’s preferences.

Condition 2: The world price line P2𝐶 , which reflects the unchanged world
price ratio, must intersect the community’s indifference curve at the point
where the domestic price line 𝐸𝐸 is tangent to the curve.
Effects of Tariff-General Equilibrium
Analysis
Point of Equilibrium (C2):

The two conditions are satisfied at the new equilibrium point 𝐶2.

At this point:The marginal rate of substitution (the rate at which consumers

are willing to trade one good for another) in consumption equals the domestic
price ratio, which reflects the higher price of Commodity Y due to the tariff.

• The world price line intersects the indifference curve, ensuring that the
world terms of trade remain consistent, but the domestic terms of trade are
now distorted by the tariff.
Effects of Tariff-General Equilibrium
Analysis
Welfare Effects and Trade Quantities:
Reduction in Trade:
• Due to the tariff, Nation 1 continues to export Commodity X and import
Commodity Y, but in smaller quantities than before. The reduction in imports of
Commodity Y and the reduction in exports of Commodity X signify a decrease in
trade volume.
Production and Consumption Changes:
• Domestic production of Commodity Y increases, which reduces reliance on
imports.
• Domestic production of Commodity X decreases, and exports of Commodity
X also fall.
Effects of Tariff-General Equilibrium
Analysis
Welfare Loss:
The imposition of the tariff leads to a reduction in welfare. This is evident from the
movement to a lower indifference curve i1​from the original indifference curve i2

The lower indifference curve signifies a lower level of overall satisfaction or utility,
as consumers are now faced with higher prices and reduced quantities of goods,
both domestically produced and imported.
Effects of Tariff-General Equilibrium
Analysis
Partial Equilibrium Analysis:

In partial equilibrium, the tariff is seen to cause a welfare loss due to the price
distortion and the inefficiencies in production and consumption. The higher
price for Commodity Y and reduced trade volume contribute to the welfare
loss.
General Equilibrium Analysis: In the general equilibrium framework, the same
conclusion holds. The tariff causes a distortion in both production and
consumption decisions, leading to a welfare loss for the small nation. The
movement to a lower indifference curve shows that Nation 1 is worse off after
the tariff is imposed.
In both analyses, the conclusion is consistent: for a small nation, tariffs reduce
national welfare, as they lead to inefficiencies and a decrease in the overall
satisfaction derived from trade and consumption.